Week 21 Day 1: Small Caps: Higher Risk, Historically Higher Reward

Small companies have more room to grow. A $500 million company can realistically double in a few years. Apple, worth $3 trillion, cannot. Historically, this growth potential has translated to higher returns. But small companies also fail more often, have less stable earnings, and their stocks swing wildly. The small-cap premium is real but requires patience.

The historical data (1926-2023, Ibbotson/Morningstar): Small-cap stocks: approximately 11.8% annual return. Large-cap stocks: approximately 10.3% annual return. Small-cap premium: approximately 1.5-2.0% per year. This sounds modest, but over 30 years: $100,000 at 10.3% = $1,930,000. $100,000 at 11.8% = $2,870,000. An extra $940,000 from the size premium alone. The catch: small caps are far more volatile. In 2008, small caps fell 37% versus large caps' 38% (similar). But in individual years, small caps can deviate significantly. They tend to underperform during recessions and outperform during recoveries. From 2010-2020, large caps (dominated by tech giants) dramatically outperformed small caps. Small-cap index funds: VB (Vanguard Small-Cap ETF, 0.05%), SCHA (Schwab U.S. Small-Cap, 0.04%), IJR (iShares Core S&P Small-Cap, 0.06%). For the small-cap value premium specifically: VBR (Vanguard Small-Cap Value, 0.07%), AVUV (Avantis U.S. Small-Cap Value, 0.25% but with DFA-style implementation).

The size premium, first documented by Banz (1981), has been one of the most debated anomalies in finance. The original finding showed small-cap stocks earning approximately 3-5% premium over large caps. However, subsequent research has raised questions. Horowitz, Loughran, and Savin (2000) showed that the premium is concentrated in January (the 'January effect') and in micro-cap stocks (under $100M market cap) that are difficult to trade at scale. Dichev (1998) and others found that much of the small-cap premium comes from the smallest, most illiquid stocks where transaction costs consume the premium. After adjusting for quality/profitability (Novy-Marx, 2013), the pure size premium largely disappears -- small-cap underperformance is concentrated in low-quality (unprofitable, high-leverage) small stocks. The investable small-cap premium exists primarily in small-cap VALUE stocks with positive profitability screens. This is the insight behind Dimensional Fund Advisors' strategy and the Avantis ETFs (AVUV): screen small caps for value AND profitability, excluding the worst-quality stocks that drive the premium's historical noise. AVUV's factor loadings show significant small (SMB), value (HML), and profitability (RMW) exposure, producing a genuine multi-factor premium that has been more reliable than the raw size factor alone.